Q3. When the use of options can be detrimental to the profitability of the compa
ID: 2799071 • Letter: Q
Question
Q3. When the use of options can be detrimental to the profitability of the company?
Q4. Harry a rice producer is concerned about short term volatility in its revenues. Rice currently sells for $ 2000 per ton. Since market is volatile so he foresee that selling price could fall as low as $ 1800 per ton or as high as $ 2200 per ton in near future. Harry is planning to supply 5000 tons to market in next month.
(A) What is the consequence if Harry does not hedge against price risk?
(B) What is the cost/benefit to Harry if he enters into a future contract to deliver 5000 tons of rice at an agreed price of $ 2100 per ton next month?
Explanation / Answer
Answer 3)
Use of options require paying extra funds in the form of the premium paid to buy the options contracts. So if market doesn't turn out to be as volatile as it was expected then this premium turns out to be an extra cost for the company and hits it's profitability real hard.
Answer 4a)
If Harry doesn't hedge against this price risk, then he stands a chance to lose out on his future revenue in case the price per tonne falls below the current $2000 as he would have to sell at a price lower than current market rates.
Answer 4b)
Assuming the price falls below $2100, Harry would stand a chance to gain as he would be able to sell at $2100 only, thereby making it a favourable outcome.
But in contrast if it gets more than $2100 then Harry would lose out as he still gets $2100 only, thereby making it an unfavourable outcome.
Comparing with current price, Harry is in a favourable position as he would get $100($2100-$2000) more than current price whenever he closes the deal.
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